Austerity still doesn’t work

January 16, 2013

Does austerity work? As many Tea Party activists and conservative economists suggest that the solution to America’s economic ills is a large spoonful of the bitter medicine of austerity, it is a question worth asking. A few months of misery may be worth it if the result is strong growth and full employment. First witness for the austerity prosecution is Latvia, for which some extravagant claims are being made. The economy of the former Soviet satellite and current member of the European Union was nose-diving in 2008-9. Now it is growing again.

Latvia’s premier, Valdis Dombrovskis, has written a self-congratulatory book, How Latvia Came through the Financial Crisis, with the help of Anders Aslund of the Peterson Institute, who claims that if America followed the Latvian example we would all be better off. Aslund extrapolates from the Latvian example, “Keynesian thinking has been tested, and it has failed spectacularly.” So what does Latvia’s experience of austerity really tell us? As you might expect, things are not quite as rosy as they are made out to be.

Back in 2008-9, Latvia was at its lowest ebb, losing a fifth of its output in just two years. Its second largest bank went bust, leaving thousands of Latvians without their lives’ savings. Unemployment was above 20 per cent, and 40 per cent among the young. Credit froze and construction, which prior to 2008 was booming thanks to low interest rates, collapsed. In December 2008, the Latvian government won a €7.5 billion bail-out from the IMF, the World Bank, and the EU – worth more than a third quarter of its annual GDP of $28.25 billion – on the condition that it introduce “structural reforms” and a generous, temporary safety net to offset the harsh effects of austerity. The reforms meant slashing public spending from 44 per cent of GDP to 36 per cent and removing legal safeguards from trade unions to reduce labor costs. By early 2009, violent rioting erupted on the streets of the capital, Riga.

As the rest of the world’s economy has slowly stabilized, fed by stimulus measures in the United States and elsewhere, so has Latvia’s. Latvia has bounced back from the dark days of 2009, but there has not been a recovery to pre-2008-9 levels. Instead, GDP has stabilized at a “new normal,” a substantially poorer level than before. And growth is now slowing. Although public spending has been cut, public debt, at 39.1 per cent of GDP, is now much the same as at the depth of the Latvian slump because the economy is much smaller than before. The Latvians are not feeling prosperous. Unemployment last year was a whopping 15.5 percent, the same as the previous year, and long term unemployment is soaring. Taking advantage of the EU’s free market in labor, increasing numbers of Latvians are emigrating to find a job. Inflation is running at 4.6 per cent and rising.

Economics is best understood as a moving picture rather than a snapshot, and the most generous assessment of Latvia’s attempt to dig itself out of the mire suggests that it is too early to say whether austerity has worked. It is certainly not such a clear and unambiguous success that it warrants becoming the model for vast and dynamic economies such as the United States. Latvia is a little larger than West Virginia with a population the size of New Mexico. Its population, or at least its older population, still lives quiescently under the pall left by decades of Soviet, then Nazi, then Soviet occupation. Many of the changes it has made since 2009 are one-off reforms, for example dismantling generous welfare provisions such as retirement at 60, inherited from communism. Its application of the rule of law – a sure sign of whether a country is truly free – is patchy.

Small nations can take economic risks that large ones cannot. Exaggerated claims are also made about Iceland’s recovery, as if a country of 319,000 – less than the population of Arlington, Texas – with a GDP of $14.06 billion has a similar economy, and similar problems, to one like ours with a population of more than 300 million and a GDP of $15.09 trillion. Why, Apple alone has a market capitalization of $460 billion. Iceland let all its banks go bust, then rescheduled its national debt in devalued Icelandic króna. America’s banks held up not only our own but the rest of the world’s economy. Economic collapse here in 2008/9 would have brought the world to its knees, which is why it was so hard back then to find an economist – even an Austrian economist – to argue that the banks should be allowed to collapse. It is easier to ignore the fact that some banks are too big to fail if you don’t have any big banks. Iceland, like Latvia, was bailed out by its neighbors. In the midst of the financial meltdown, America was the only nation big enough to bail itself out and ever since it has been bailing out the world. Small countries can batten down the hatches and introduce beggar-thy-neighbor policies, but that is not an option for America. If we were to introduce austerity measures like the European Union, cutting public spending and raising taxes, the fragile world economic recovery would gutter then snuff out like a candle. Nor can America devalue its currency. Even when its credit rating is downgraded and Congress shouts from the roof of the Capitol that we are broke, the dollar stands firm, bolstered by its pivotal role as the world reserve currency.

Japan has a big economy – at $5.87 trillion, the third largest in the world – and it, too, finds it has mostly exhausted its attempts to escape its wobbling business cycle and shock itself into sustained growth. Japan’s government has tried just about everything since its economy became mired in 1990 and has the biggest public debt in the world with a debt-to-GDP ratio of 200 per cent. But it is certainly not looking for inspiration from Latvia or Iceland’s experiment in austerity. On the contrary, it has gone back to Keynesian notions to justify a $5.3 billion stimulus, to be spent on improving infrastructure, the first installment on a $2.25 trillion program to be spent over the next decade. The stock market, which at one time was considered by some academic economists as an infallibly accurate bellwether of good sense, soared on the news. With Britain about to enter a triple-dip recession and even the mighty German economy now teetering on the edge of a slump, political leaders beyond Japan have, like Japan’s, come to a fork in the road: to promote growth or impose austerity.

Here, with the president having made permanent tax cuts for all but the super-rich, the American economy gallops towards its next Congress-made hurdle. The GOP, firmly under the thrall of the Tea Party, which was born of anger that America’s banks were not allowed to fail in 2009, is demanding austerity. The Republicans, once boosters of free enterprise and Wall Street and patriotic guardians of the national economy, are fast becoming the enemies of big business and profit. Peggy Noonan, conservatism’s mother superior, offers this Latvian advice to her flailing party: “Declare for Main Street over Wall Street, stand for the little guy against the big interests… Republicans should go to the populist right on the issue of bank breakup. Too big to fail is too big to continue. The megabanks have too much power in Washington and too much weight within the financial system. People think the GOP is for the bankers. The GOP should upend this assumption.” Latvia and Iceland, which let their banks go bust, are too small to offer a way forward. Now more than ever what we need is not more small thinking but better big ideas.

Nicholas Wapshott’s Keynes Hayek: The Clash That Defined Modern Economics is published by W.W. Norton. Read extracts here.

PHOTO: A woman wearing a pair of giant scissors on her head takes part in a protest against government public health care cuts in Barcelona November 11, 2012. REUTERS/Albert Gea


We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see

“Economics is best understood as a moving picture…Latvia’s attempt to dig itself out of the mire suggests that it is too early to say whether austerity has worked.”

Yet the headline reads: “Austerity still doesn’t work”…?

Did the editor choose the title without understanding the article…?

Posted by econdoc37 | Report as abusive

small is still beautiful

Posted by quakeyjase | Report as abusive